Single-state focus: Manager's concentration on state funds yields opportunity
Managing single-state municipal bond mutual funds comes with its perks and perils, but Josh Larson, co-portfolio manager at Integrity Viking Funds, finds a balance between the two.
Larson said the firm’s geographic location and local expertise gives it a unique perspective on six states where it offers single-state municipal bond mutual funds, including North Dakota, Kansas, Maine, Nebraska, Oklahoma, and Montana.
Based in North Dakota, Larson relies on the investment management company’s familiarity with specific local school districts, counties, and municipalities within each state as an advantage to managing his funds.
“With the small states you get to know which credits are healthy — and which ones are struggling and then avoid those issuers,” he said.
The firm’s close proximity and presence in those relatively small states allows Larson and his co-managers to “kick the tires” when analyzing new or existing credits to add to the funds’ holdings, he said.
Meanwhile, another advantage is less competition for smaller sized deals where the firm offers single-state funds, according to Larson, who joined the firm in 2010. Prior to becoming a co-portfolio manager in 2014, he was a research analyst for all of Viking’s municipal bond funds.
The smaller deals are in Larson’s wheelhouse, whereas the large national funds have difficulty getting enough allotments for their customers to justify being in deals of that size.
“We can pick up odd lots that are meaningful for us, but wouldn’t move the needle for a national fund,” he explained.
For instance, Integrity runs the only single-state tax-exempt fund in North Dakota, which “makes us unique since we are not up against other single-states funds” when it comes to participating in new deals, Larson said.
“In most of the states we manage single-state funds, we are the only fund in the state,” he continued.
Lesser-known deals of high quality from single states don’t get national attention, which is one of the perks, he noted. He explained that deals of $25 to $30 million have much less chance of being oversubscribed — or sometimes not at all—whereas those sized at $100 million or more gain national attention and end up seven to eight times oversubscribed.
Double-A-rated bonds from a $10 million Nesson, N.D., Public School District #2 offering on July 16 offered 4% coupon bonds priced at a 2.75% yield to the 2027 call — and kicks to 3.38% to the 2039 maturity.
“There’s not many national muni accounts looking at that deal,” Larson said, adding that he finds value by picking up bonds with solid credit, such as GOs that are backed by the full faith and credit of the issuer and lack national competition.
With this summer’s net negative issuance driving performance, it helps being able to look at smaller deals, he said.
“We have to give a little extra attention to detail, but that’s where the value is for us right now,” he said.
The state-specific funds he manages have been impacted very little, if at all, by tax reform as part of the Tax Cuts and Jobs Act of 2017, he noted.
“The states we deal in haven’t seen a great impact from tax law changes — other than on a national overall level,” Larson said. “I wouldn’t say they had any state specific tax changes.”
In addition, the states that Integrity offers tax-exempt funds in have relatively low state income taxes — with the exception of Maine, which is a little higher-than-average, ranging between 5.80% and 7.15%, according to Larson,
For 2019, the maximum state tax rate in the states the firm offers funds ranges between 2.90% in North Dakota, which is below the national average, and 7.15% in Maine, which is higher than average, according to Larson. Montana is at 6.90% and Nebraska is 6.84% — both of which would probably be considered on the higher end of the national average. Oklahoma and Kansas are at 5% and 5.70% respectively, just around the national average.
At the same time, Larson said one peril of managing the Maine Municipal Fund, for example, is the challenge of finding supply in a state with a more limited number of issuers and availability of high-quality credits.
But, Larson strives to employ an overall strategy aimed at delivering capital preservation and a high level of current income among all of the state-specific municipal funds he co-manages.
All of the funds have a double-A-rated or better average credit quality; average duration of four to five years, and average intermediate maturity of eight to 15 years, as the intermediate structure promotes less volatility, according to Larson.
He said the funds strive to meet or outperform benchmarks in the Morningstar single-state intermediate municipal fund category.
Five of his six funds have posted positive five-year total return performance versus the Morningstar single-state intermediate category, as of June 30, with the Kansas Municipal Fund returning 0.12%; the Nebraska Municipal Fund 0.21%; the Oklahoma Municipal Fund, 0.22%; the Viking Tax-Free Fund for Montana, 0.14%, and the Viking Tax-Free Fund for North Dakota posting 0.07%.
Only the Maine Municipal Fund returned negative 0.51%.
Attractive yields, smaller deals
Larson advises that bonds in the 15 to 20-year range — and occasionally in 25 years — from smaller-sized deals currently provide the best value on the municipal yield curve.
Twenty-year maturities rated A-plus to double-A are offering 3% at par, Larson said, pointing to recent school district and essential service revenue bonds with attractive yields providing the best value lately.
For instance, double-A-rated general obligation bonds from a $35 million Fargo, N.D., deal due in 2039 were recently priced at par to yield 3%, and got limited national attention when the deal was priced on July 16, according to Larson.
Its 2038 maturity was priced with a 4% coupon and 2.70% yield — which was a 66 basis-point spread to the triple-A MMD scale at the time.
The deal compares to the generic, triple-A GO scale, which was yielding 2.04% as of July 16, and currently yielding 1.72%as of Aug. 22, according to Municipal Market Data.
By comparison, a $100 million Omaha-Douglas Public Building Commission issue received national attention and its maturities were heavily oversubscribed by as much as seven times or more when it was priced on July 10.
The deal — which was rated Aa3 by Moody’s Investors Service and AA-plus by Standard & Poor’s — had a 2038 maturity also priced with a 4% coupon, but 2.61%, a spread of 56 basis points to the triple-A MMD scale at the time, according to MMD.
Since most of Larson’s funds have distribution rates of an average of between 2.80% and 2.90% of tax-exempt income, they are considered attractive, according to Larson, when compared to 10-year Treasuries, which dropped to 1.50% on Aug. 26 on Monday after President Trump’s announcement of renewed trade talks with China.
“When you look at the high 2% distribution rate on a tax-exempt basis that’s pretty attractive on a tax adjusted basis,” he said, noting that the distribution rate is for the I shares of the funds, according to Larson.
Despite municipals’ spotty supply in 2019 and historic low yields -—Larson continues to advocate tax-exempt investments for Viking shareholders.
“You can never have too much tax-free income,” he explained. “Investors realize where the current rates are and are willing to justify putting money to work at these lower rates,” expecting Larson and his co-managers to locate value, he explained.
So far, year to date, he says while supply has been challenging, he has still been able to find bonds for his state specific funds, despite the net negative issuance.
“We don’t have trouble finding bonds we need — the states we are buying bonds in are all doing well financially and we are not too worried about the credit quality,” he explained.
Larson expects supply to pick up and be slightly ahead of last year’s pace in the fourth quarter of the year, which will bode well for the supply demand imbalance.
“Demand is solid and supply is not quite there,” he explained, adding that redemption proceeds need to be reinvested yet there is not enough new supply to compensate for the called and maturing bonds.
Though Larson and his co-managers don’t predict interest rates, he said the municipal market is already forward-looking and has a 25 to 50 basis- point cut later this year or early 2020 “baked” into the current market.
“Barring any surprises, we are range-bound on interest rates,” Larson said.
While he may slightly adjust or alter his focus on the long end of the yield curve due to changing market conditions, his overall strategy will remain.
“We have money coming in — and we will put it to work where we find value in the current environment — and that won’t change,” he said.
Larson’s advice for investors heading into the fourth quarter?
“Stay the course,” he said. “Munis are a great place to be; you can’t beat the safety of them and you can never have too much tax-free income.”
Going forward, Larson said the net negative issuance should continue to drive municipal prices higher in the remainder of the third quarter, which should buoy the market by increasing the value of current holdings.